Presentation on theme: "Building the short run AD-AS model from the IS-LM framework"— Presentation transcript:
1Building the short run AD-AS model from the IS-LM framework AD-AS Short RunBuilding the short run AD-AS model from the IS-LM framework
2Theory of Short Run Fluctuations The IS curve is generated from the Keynesian Cross and the LM curve is generated from the market for real money balances.Now we will generate the AD curve from IS-LM and use short run and long run models of AS to explain short run economic fluctuations.KeynesianCrossISCurveIS-LMModelADCurveMoneyMarketLMCurveAD-ASModelShort-runFluctuationsExplanationASCurve
3Fiscal Policy and the IS curve (government expenditure) An increase in government purchases shifts the IS curve to the right.The IS curve shifts to the right by ΔG/(1-MPC),...rLM...and the interest rate.r2r1IS2IS1…which raises income...YY1Y2
4Fiscal Policy and the IS curve (government expenditure) A decrease in taxes shifts the IS curve to the right.The IS curve shifts to the right by ΔTxMPC/(1–MPC),...rLM...and the interest rate.r2r1IS2IS1…which raises income...YY1Y2
5Fiscal Policy and the IS curve (tax changes) Note that government expenditure has a larger effect than does the same change in taxes.
6Monetary Policy and the LM curve An increase in the money supply shifts the LM curve to the right,...rLM1LM2...and lowers the interest rate.r1r2IS1…which raises income...YY1Y2
7Monetary and Fiscal Policy Interactions …if the money supply is held constant, the LM curve stays the same.How the economy responds to a tax increase depends on the response of the money supply.rLM1The interest rate and output fall.IS1IS2Y
8Monetary and Fiscal Policy Interactions …if to hold the interest rate constant, the money supply contracts.How the economy responds to a tax increase depends on the response of the money supply.rLM2LM1Only output falls.IS1IS2Y
9Monetary and Fiscal Policy Interactions …if to hold income constant, the money supply expands.How the economy responds to a tax increase depends on the response of the money supply.rLM1LM2IS1Only the interest rate falls.IS2Y
10IS-LM as a theory of Aggregate Demand LM(P2)A higher price level P shifts the LM curve upward…LM(P1)…lowering income Y.IS1YWe now allow price level to vary in the IS-LM model. This provides a theory for the position and slope of the AD curve.Y2Y1The AD curve summarizes the relationship between P and Y.PP2P1ADYY2Y1
11IS-LM as a theory of Aggregate Demand LM(P1)A monetary expansion shifts the LM curve outward…LM(P1)…increasing income Y.IS1YY1Y2If we hold price constant we can see the effects of monetary and fiscal policy on AD via IS-LM.Increasing AD at any given price level.PP1AD2AD1YY1Y2
12IS-LM as a theory of Aggregate Demand LM(P1)A fiscal expansion shifts the IS curve outward…IS2IS1Y…increasing income Y.Y1Y2Increasing AD at any given price level.PP1AD2AD1YY1Y2
13IS-LM and AD-AS the Short Run and the Long Run Now let’s add short-run and long-run AS to our IS-LM and AD models. Assume the economy is operating below full employment output.LRASrLM(P1)LM(P2)As price falls money demand decreases and the LM curve shifts out.12ISYIn the short run price is fixed at P1 and equilibrium is at point 1.PIn the long run price falls to P2, quantity demanded increases, and equilibrium moves to point 2. This is characterized by a shifting SRAS curve.P1SRAS11P2SRAS22AD1Long run equilibrium is achieved at point 2.Y
14The Algebra of the IS-LM theory of AD The algebra behind the system is a bit tedious. But, by solving the LM curve for “r” and plugging into the IS curve which contains “r” on the right hand side you obtain the IS-LM equilibrium condition or AD curve.
15The Algebra of the IS-LM theory of AD The IS curve boils down to…The LM curve boils down to…Plugging “r” into the IS curve and solving for Y yields…
16ConclusionsIn this section we derived the AD curve via the IS-LM equilibrium condition. We looked at fiscal and monetary policy effects on the IS-LM model. We looked at the shifting effects that monetary and fiscal policies have on the AD curve and used the IS-LM model with the AD-AS model to explain short run and long run changes to the economy.